Fitch Ratings has affirmed El Paso Electric Company's (EPE) Long-Term Issuer Default Rating (IDR) at 'BBB'.
The Rating Outlook is Stable. Fitch has also affirmed EPE's senior unsecured debt at 'BBB+'. EPE's ratings reflect its business operations as a vertically integrated electric utility serving customers in Texas and New Mexico, regulatory environments that Fitch considers relatively challenging.
Fitch expects EPE's FFO leverage to average around 4.9x from 2022 through 2026 decreasing from a peak of 5.4x in 2020, following resolution of rate case proceedings and equity infusions from EPE's ultimate parent, the Infrastructure Investments Fund (IIF), to support the regulated capital structure and a significant capital program.
Key Rating Drivers
Regulated Operations: EPE is a vertically integrated electric utility serving customers in west Texas and southern New Mexico. About 77% of the customer base is in Texas, which Fitch considers a good service territory. EPE has experienced above industry average customer and sales growth, which are primarily driven by transition from evaporative coolers to refrigerated air conditioning. EPE, unlike many other vertically integrated utilities, does not have any coal generation and its current generation mix includes more than 70% of generation from carbon neutral resources.
Relatively Challenging Regulatory Environment: Fitch believes New Mexico, and to a lesser degree Texas, have challenging regulatory environments. Both states have typically utilized historical test year filings, with partial true ups. Utilities in Texas and New Mexico have historically received authorized ROEs that are slightly lower than the nationwide average. Regulatory lag from the use of a historical test year in Texas and other factors in the rate-setting process in New Mexico have made it difficult for EPE to earn its authorized ROEs.
Offsetting some of the challenges are supportive rate mechanisms such as fuel and purchased power recovery mechanisms and riders for energy efficiency program costs. In Texas, EPE has been able to recover its investment in distribution and transmission through riders, which provide some protection from regulatory lag in between rate cases.
Leverage Continuing to Improve Since 2021: Fitch expects FFO leverage to continue to improve at EPE from its 2020 high following equity infusions from IIF, despite disappointing rate case outcome in New Mexico. FFO leverage stood at 5.2x in 2021, which was higher than expected. Factors that stressed EPEs credit metrics in 2021 include weak New Mexico rate case outcome, and a lower than projected equity contribution from the parent.
Fitch projects leverage to improve to an average of 4.9x from 2022 through 2026. EPEs parent is expected to continue to make equity investments through the forecast period to support the prescribed regulatory structure.
Rate Case Filings: EPE is currently proceeding through an extended rate case process in Texas. In June 2021, EPE filed for a $69.7 million gross increase in rates, based on a 10.3% return on equity with a 51% capital structure. In May 2022, EPE announced that a settlement had been reached between the utility, the city of El Paso, and all other parties to the 2021 rate case, but not yet approved by the PUCT. Full details of the settlement have not been announced, but the rate increase agreed upon was said to be 2%, compared to the 13.5% requested.
EPE filed a rate case in New Mexico in May 2020 requesting a revenue requirement increase of $5.1 million. The request was based on a 10.3% ROE and a 51% equity ratio on a rate base of $467 million. The final order implemented a rate decrease of $4 million and a below average ROE of 9%. EPE appealed the PRC's ruling to the New Mexico Supreme Court. There has been no change to the final order following appeal. The rate case result is disappointing as it underscores the challenging regulatory environment in New Mexico.
Large Capital Program: Utility construction expenditures of $1.8 billion from 2022-2026 consist primarily of new generation, expanding and updating the transmission and distribution systems, and replacements at Palo Verde. Significant generation investments include the construction of Newman Unit 6 a 223 MW unit expected to come online in 2023. EPE will spend additional money on other generation and battery storage projects while also acquiring new renewable generation and storage sources through PPAs.
Ownership Structure: On July 29, 2020, EPE merged with an affiliate of IIF, an investment vehicle advised by JPMIM. The transaction valued at $4.3 billion consisted of a $2.8 billion equity purchase price and assumption of $1.5 billion of existing debt at EPE. The equity purchase price was funded with a $625 million term loan at Sun Jupiter Holdings LLC (Sun Jupiter) and $2.2 billion of equity from IIF. EPE's ratings consider its ultimate owner's support of the regulatory capital structure.
Significant Ring-fencing Measures: The utility is ring-fenced from Sun Jupiter with strong legal provisions including a majority independent board (7/10), separate books/record keeping, no pooled cash, no cross defaults, no intercompany lending, no credit guarantees, a non-consolidation opinion, and restrictions on dividends, which are limited to net income and must keep EPE in compliance with authorized regulatory equity ratios.
In addition, EPE must maintain 'BBB' credit ratings from at least one major credit ratings agency (out of two) to be able to pay dividends, except for contractual tax payments, until otherwise ordered by the Public Utilities Commission of Texas (PUCT) and NMPRC or EPE's credit rating at one of the major credit rating agencies returns to 'BBB'. IIF has committed to maintain a controlling ownership interest in EPE for at least 10 years post-closing.
EPE, with its 'BBB' Long-Term IDR, is appropriately positioned relative to its peers Cleco Power LLC (Cleco; BBB/Stable), Puget Sound Energy (PSE; BBB+/Negative), Indianapolis Power & Light Company (IPL; BBB+/Stable) and Southwestern Public Service Company (SPS; BBB/Stable). EPE is similar to PSE, Cleco and IPL, as regulated electric utilities owned by private equity investors with substantial parent-level debt.
Cleco, PSE, SPS and IPL all own coal generation, while EPE's generation fleet is cleaner with nuclear being the main baseload generation source. Cleco and IPL benefit from a more supportive regulatory environment in Louisiana and Indiana, respectively, than EPE and SPS, which are both operating in Texas and New Mexico. PSE operates in a challenging operating environment in Washington State.
EPE and SPS operate in the same relatively challenging regulatory environment in New Mexico and Texas with regulatory lag, which puts pressure on credit metrics in between rate cases due to the large capex program in the next several years. Strong customer growth, well above industry average, and transmission and distribution riders in Texas help offset some of the regulatory lag in between the rate cases.
Fitch forecasts EPE's FFO leverage to average around 4.9x in the 2022- 2026 period, which is higher than 4.5x-4.6x through 2024 at SPS. Cleco's FFO leverage was above its negative sensitivity threshold in 2020 and 2021, but is projected to improve to around 3.6x by2024, compared with PSE's FFO leverage in the low-3x range over the same period. IPL's leverage is projected to average around 4.1x over the next couple years.
PSE's, Cleco's and IPL's ratings are upwardly constrained by their parent holding companies. Cleco Power's IDR is only one notch higher than Cleco's, while PSE's and IPL's IDRs are two notches higher than their parents', due to Cleco having much higher parent-only debt of around 46% in 2021, compared with PE's approximately 30% and IPALCO's 33%. EPE's parent debt is lower than its peers and required to be extinguished within five years from the merger closure.
Fitch's Key Assumptions Within The Rating Case for the Issuer:
Long-term debt issuances to maintain targeted regulatory capitalization;
Utilization of $400 million revolving credit facility (RCF) to manage working capital;
Equity contributions/dividend payments to balance the capital structure and support credit ratings;
Capital investment plan of $1.8 billion from 2022-2026;
Allowed ROE in NM of 9% and TX to be below current allowed post 2021.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Given the large capex plan and challenging regulatory environment, a positive rating action is unlikely in the near term;
Over the longer term, a positive rating action could occur if regulatory lag were to improve materially and if Fitch were to expect FFO leverage to remain less than 4.5x on a sustained basis.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Materially unfavorable regulatory developments;
FFO leverage expected to exceed 5.3x on a sustained basis.
Best/Worst Case Rating Scenario
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
Liquidity and Debt Structure
Adequate Liquidity: Fitch considers liquidity for EPE adequate. As of March 31, 2022, EPE had approximately $213.4 million of unused committed credit arrangements with banks under the revolving credit facility and $20.2 million in cash outstanding.
A majority of the used RCF is related to working capital purposes. Near-term debt maturities are minimal, with $150 million of 3.30% senior notes maturing later this year. On Feb. 15, 2022, EPE issued 2.91% Senior Unsecured Notes of $150 million with a maturity date of Sept. 1, 2032, and 3.54% senior unsecured notes of $200.0 million with a maturity date of Feb. 15, 2052. The $200 million unsecured senior notes were funded on Feb. 15, 2022, whereas the $150 million unsecured senior notes will be funded on Sept. 1, 2022.
El Paso Electric Company (EPE) is a private utility engaged in the generation, transmission and distribution of electricity in west Texas and southern New Mexico. El Paso Electric's rate and services are regulated by Public Utilities Commission of Texas (PUCT), New Mexico Public Regulation Commission (NMPRC), the FERC and incorporated municipalities in Texas (such as the City of El Paso). EPE serves approximately 441,812 residential, commercial, industrial, public authority and wholesale customers.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Entity / Debt
El Paso Electric Company
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